UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2017March 31, 2018

OR

For the transition period from _______________________ to _______________________

Commission file number:  001-35245

(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code: (720) 616-4300

SRC ENERGY INC.

Index

The accompanying notes are an integral part of these condensed consolidated financial statements

The accompanying notes are an integral part of these condensed consolidated financial statements

The accompanying notes are an integral part of these condensed consolidated financial statements

SRC ENERGY INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

The condensed consolidated financial statements include the accounts of the Company, including its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.  The Company prepares its condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (“US GAAP”).

In our opinion, the unaudited condensed consolidated financial statements contained herein reflect all adjustments, consisting solely of normal recurring items, which are necessary for the fair presentation of the Company's financial position, results of operations, and cash flows on a basis consistent with that of its prior audited financial statements.  However, the results of operations for interim periods may not be indicative of results to be expected for the full fiscal year.

Based on the current demand for oil and natural gas, the availability of other buyers, the multiple contracts for sales of our products, and the Company having the option to sell to other buyers if conditions warrant, the Company believes that the loss of our existing customers or individual contractcontracts would not have a material adverse effect on us. Our oil and natural gas production

Accounts receivable consist primarily of receivables from oil, natural gas, and NGL sales and amounts due from other working interest owners who are liable for their proportionate share of well costs. The Company typically has the right to withhold future revenue disbursements to recover outstanding joint interest billings on outstanding receivables from joint interest owners.

Customers with balances greater than 10% of total receivable balances as of each of the periods presented are shown in the following table (these companies do not necessarily correspond to those presented above):

The Company operates exclusively within the United States of America, and except for cash and cash equivalents, all of the Company’s assets are utilized in, and all of our revenues are derived from, the oil and gas industry.

In March 2016,May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting StandardsStandard Update ("ASU") 2016-09, “Improvements to Employee Share-Based Payment Accounting”2014-09, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2016-09”2014-09”), which intendsestablishes a comprehensive new revenue recognition standard designed to improvedepict the accountingtransfer of goods or services to a customer in an amount that reflects the consideration the entity expects to receive in exchange for share-based payment transactions.those goods or services. In March 2016, the FASB released certain implementation guidance through ASU 2016-09 changes several aspects2016-08 (collectively with ASU 2014-09, the "Revenue ASUs") to clarify principal versus agent considerations. The Revenue ASUs allow for the use of either the accounting for share-based payment award transactions, including: (1) Accountingfull or modified retrospective transition method, and Cash Flow Classification for Excess Tax Benefits and Deficiencies, (2) Forfeitures, and (3) Tax Withholding Requirements and Cash Flow Classification. ASU 2016-09 isthe standard will be effective for public businesses for fiscal years, and interimannual reporting periods within those fiscal years, beginning after December 15, 2016,2017 including interim periods within that period, with early adoption permitted. Wepermitted for annual reporting periods beginning after December 15, 2016. The Company adopted this pronouncementthe guidance using the modified retrospective method with the effective date of January 1, 2017. Upon adoption of this standard, we no longer estimate the total number of awards for which the requisite service period will2018. The Company did not be rendered, and effective January 1, 2017, we began accounting for forfeitures when they occur. We applied this accounting change on a modified retrospective basis withrecord a cumulative-effect adjustment to the opening balance of $0.1 million to retained earnings as of the date of adoption.no adjustment was necessary. The adoption of the other provisionsRevenue ASUs did not materially impact net income or cash flows. See Note 14 for the consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)" ("ASU 2016-02"), which establishes a comprehensive new lease standard designed to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply. An entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with previous US GAAP. ASU 2016-02 is effective for public businesses for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted.2018. We are currently evaluating the impact of the adoption of this standard on our condensed consolidated financial statements.

There were various updates recently issued by the FASB, most of which represented technical corrections to the accounting literature or application to specific industries and are not expected to a have a material impact on our reported financial position, results of operations, or cash flows.

The capitalized costs related to the Company’s oil and gas producing activities were as follows (in thousands):

The Company periodically reviews its oil and gas properties to determine if the carrying value of such assets exceeds estimated fair value. For proved producing and non-producing properties, the Company performs a ceiling test each quarter to determine whether there has been an impairment to its capitalized costs. At September 30,March 31, 2018 and 2017, the calculated value of the ceiling limitation exceeded the carrying value of our oil and gas properties subject to the test, and no impairment was necessary. At September 30, 2016, the carrying value of our oil and gas properties subject to the test exceeded the calculated value of the ceiling limitation, resulting in an impairment of $25.5 million for the three months ended September 30, 2016. Impairments for the nine months ended September 30, 2016 totaled $215.2 million. No impairments were recognized for the comparable 2017 periods.necessary.

In August 2017, we entered into an agreement with another party to trade approximately 3,200 net acres of the Company's non-contiguous acreage for approximately 3,200 net acres within the Company's core operating area. This transaction closed in the fourth quarter of 2017. Also in August 2017, we acquired approximately 1,000 net acres of developed and undeveloped leasehold and mineral interests, along with the associated production, for a total purchase price of $22.6 million, composed of cash and assumed liabilities.

In March 2017, we closed an acquisition comprised primarily of developed and undeveloped oil and gas leasehold interests for a total purchase price of $25.0$25.1 million, composed of cash and assumed liabilities.

DD&A consisted of the following (in thousands):

Capitalized costs of proved oil and gas properties are depleted quarterly using the units-of-production method based on a depletion rate, which is calculated by comparing production volumes for the quarter to estimated total reserves at the beginning of the quarter. For the three and nine months ended September 30, 2017,March 31, 2018, production of 3,7154,086 MBOE and 8,280 MBOE, respectively, represented 2.2% and 4.8%1.7% of estimated total proved reserves, respectively.reserves. For the three and nine months ended September 30, 2016,March 31, 2017, production of 9931,597 MBOE and 3,050 MBOE, respectively, represented 0.8% and 2.4%1.1% of estimated total proved reserves, respectively.reserves. DD&A expense was $9.08 per BOE and $9.70$8.28 per BOE for the three months ended September 30,March 31, 2018 and 2017, and 2016, respectively, and was $8.86 per BOE and $10.82 per BOE for the nine months ended September 30, 2017 and 2016, respectively.

Upon completion or acquisition of a well, the Company recognizes obligations for its oil and natural gas operations for anticipated costs to remove and dispose of surface equipment, plug and abandon the wells, and restore the drilling site to its original use.  The estimated present value of such obligations is determined using several assumptions and judgments about the ultimate settlement amounts, inflation factors, credit-adjusted discount rates, timing of settlement, and changes in regulations.  Changes in estimates are reflected in the obligations as they occur.  If the fair value of a recorded asset retirement obligation changes, a revision is recorded to both the asset retirement obligation and the capitalized asset retirement cost.  The following table summarizes the changes in asset retirement obligations associated with the Company's oil and gas properties (in thousands):

In September 2017,On April 2, 2018, the lendersCompany entered into a second amended and restated credit agreement (the “Restated Credit Agreement”) with certain banks and other lenders. The Restated Credit Agreement provides for a maximum credit amount of $1.5 billion, an aggregate elected commitment of $450 million, and a borrowing base of $550 million. The Company is currently allowed to borrow up to $450 million under the Revolver completed their regular semi-annual redeterminationRestated Credit Agreement, less any outstanding amounts. In addition, the Restated Credit Agreement extends the maturity date of our borrowing base.  The borrowing base was increasedthe facility from $225December 2019 to April 2023, reflects certain reductions in interest rates applicable to borrowings under the facility, and adds a $25 million to $400 million.swingline facility. The next semi-annual redetermination is scheduled for AprilNovember 2018.

Certain of the Company’s assets, including substantially all of theits producing wells and developed oil and gas leases, have been designated as collateral under the Revolver.Restated Credit Agreement. The borrowing commitmentamount available to be borrowed is subject to scheduled redeterminations on a semi-annual basis. If certain events occur or if the bank syndicate or the Company so elects in certain circumstances, an unscheduled redetermination could be undertaken.

The RevolverRestated Credit Agreement contains covenants that, among other things, restrict the payment of dividends and limit our overall commodity derivative position to a maximum position that varies over 5 years as a percentage of estimated proved developed producing or total proved reserves as projected in the semi-annual reserve report.

  

of September 30, 2017,March 31, 2018, the most recent compliance date, the Company was in compliance with these loan covenants and expects to remain in compliance throughout the next 12-month period.

The Indenture contains covenants that restrict the Company’s ability and the ability of any restrictedcertain of its subsidiaries to, among other things:restrictions and limitations: (i) incur additional indebtedness; (ii) incur liens; (iii) pay dividends; (iv) consolidate, merge, or transfer all or substantially all of its or their assets; (v) engage in transactions with affiliates; or (vi) engage in certain restricted business activities.  These covenants are subject to a number of exceptions and qualifications.

The Company has entered into commodity derivative instruments as described below. Our commodity derivative instruments may include but are not limited to "collars," "swaps," and "put" positions. Our derivative strategy, including the volumes and commodities covered and the relevant strike prices, is based in part on our view of expected future market conditions and our analysis of well-level economic return potential. In addition, our use of derivative contracts is subject to stipulations set forth in the Revolver.

The Company may, from time to time, add incremental derivatives to cover additional production, restructure existing derivative contracts, or enter into new transactions to modify the terms of current contracts in order to realize the current value of the Company’s existing positions. The Company does not enter into derivative contracts for speculative purposes.

The use of derivatives involves the risk that the counterparties to such instruments will be unable to meet the financial terms of such contracts. The Company’s derivative contracts are currently with five counterparties and an exchange. Three of the counterparties are lenders in the Revolver. The Company has netting arrangements with the counterparties that provide for the offset of payables against receivables from separate derivative arrangements with the counterparty in the event of contract termination. The derivative contracts may be terminated by a non-defaulting party in the event of default by one of the parties to the agreement.

The Company’s commodity derivative instruments are measured at fair value and are included in the accompanying condensed consolidated balance sheets as commodity derivative assets or liabilities. Unrealized gains and losses are recorded based on the changes in the fair values of the derivative instruments. Both the unrealized and realized gains and losses resulting from contract settlement of derivatives are recorded in the condensed consolidated statements of operations. The Company’s cash flow is only impacted when the actual settlements

Offsetting of Derivative Assets and Liabilities

As of September 30, 2017March 31, 2018 and December 31, 2016,2017, all derivative instruments held by the Company were subject to enforceable master netting arrangements held by various financial institutions. In general, the terms of the Company’s agreements provide for offsetting of amounts payable or receivable between the Company and the counterparty, at the election of either party, for transactions that occur on the same date and in the same currency. The Company’s agreements also provide that, in the event of an early termination, each party has the right to offset amounts owed or owing under that and any other agreement with the same counterparty. The Company’s accounting policy is to offset these positions in its condensed consolidated balance sheets.

The following table provides a reconciliation between the net assets and liabilities reflected on the accompanying condensed consolidated balance sheets and the potential effect of master netting arrangements on the fair value of the Company’s derivative contracts (in thousands):

The amount of gain (loss) recognized in the condensed consolidated statements of operations related to derivative financial instruments was as follows (in thousands):

Realized gains and losses include cash received from the monthly settlement of derivative contracts at their scheduled maturity date andnet of the previously incurred premiums attributable to settled commodity contracts. The following table summarizes derivative realized gains and losses during the periods presented (in thousands):

Credit Related Contingent Features

As of September 30, 2017,March 31, 2018, three of the six counterparties to the Company's derivative instruments were members of the Company’s credit facility syndicate. The Company’s obligations under the credit facility and its derivative contracts are secured by liens on substantially all of the Company’s producing oil and gas properties. The agreement with the fourth counterparty,and fifth counterparties, which isare not a lenderlenders under the credit facility, is unsecured and does not require the posting of collateral. The agreement with the fifthsixth counterparty, which is not a lender under the credit facility, may require the posting of collateral if in a liability position. The agreement with the sixth counterparty is subject to an inter-creditor agreement between the counterparty and the Company’s lenders under the credit facility.

The financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels.

The Company’s non-recurring fair value measurements include unproved properties, asset retirement obligations, and purchase price allocations for the fair value of assets and liabilities acquired through business combinations and certain asset acquisitions. Please refer to Notes 2, 3, and 5 for further discussion of unproved properties, business combinations and asset acquisitions, and asset retirement obligations, respectively.

The Company determines the estimated fair value of its unproved properties using market comparables, which are deemed to be a Level 3 input. See Note 2 for additional information.

The Company determines the estimated fair value of its asset retirement obligations by calculating the present value of estimated cash flows related to plugging and abandonment liabilities using Level 3 inputs. The significant inputs used to calculate such liabilities include estimates of costs to be incurred, the Company’s credit-adjusted risk-free rate, inflation rates, and estimated dates of abandonment. The asset retirement liability is accreted to its present value each period, and the capitalized asset retirement cost is depleted as a component of the full cost pool using the units-of-production method. See Notes 3 and 5 for additional information.

Commodity Derivative Instruments

The Company determines its estimate of the fair value of commodity derivative instruments using a market approach based on several factors, including quoted market prices in active markets, quotes from third parties, the credit rating of each counterparty, and the Company’s own credit standing. In consideration of counterparty credit risk, the Company assessed the possibility of whether the counterparties to its derivative contracts would default by failing to make any contractually required payments. The Company considers the counterparties to be of substantial credit quality and believes that they have the financial resources and willingness to meet their potential repayment obligations associated with the derivative transactions. At September 30, 2017,March 31, 2018, derivative instruments utilized by the Company consist of putsswaps and collars. The oil and natural gas derivative markets are highly active. Although the Company’s derivative instruments are based on several factors including public indices, the instruments themselves are traded with third-party counterparties. As such, the Company has classified these instruments as Level 2.

Fair Value of Financial Instruments

The Company’s financial instruments consist primarily of cash and cash equivalents, accounts receivable, accounts payable, commodity derivative instruments (discussed above), notes payable, and credit facility borrowings. The carrying values of cash and cash equivalents, cash held in escrow, accounts receivable, and accounts payable are representative of their fair values due to their short-term maturities. Due to the variable interest rate paid on the credit facility borrowings, the carrying value is representative of its fair value.

The fair value of the Senior Notesnotes payable is estimated to be $84.8$509.9 million at September 30, 2017.March 31, 2018. The Company determined the fair value of its notes payable at September 30, 2017March 31, 2018 by using observable market based information for debt instruments of similar amounts and duration. The Company has classified the notes payable as Level 2.

The components of interest expense are (in thousands):

In addition to cash compensation, the Company may compensate employees and directors with equity-based compensation in the form of stock options, performance-vested stock units, restricted stock units, stock bonus shares, warrants, and other equity awards. The Company records its equity compensation by pro-rating the estimated grant dategrant-date fair value of each grant over the period of time that the recipient is required to provide services to the Company (the "vesting phase"period").  The calculation of fair value is based, either directly or indirectly, on the quoted market value of the Company’s common stock.  Indirect valuations are calculated using the Black-Scholes-Merton option pricing model or a Monte Carlo Model. For the periods presented, all stock-based compensation was either classified as a component within general and administrative expense in the Company's condensed consolidated statements of operations or, for that portion which is directly attributable to individuals performing acquisition, exploration, and development activities, was capitalized to the full cost pool. As of September 30, 2017,March 31, 2018, there were 4,500,000 common shares authorized for grant under the 2015 Equity Incentive Plan, of which 86,4646,217,650 shares were available for future grants.had been granted. The shares available for future grant exclude 951,884granted include 1,555,263 shares which have been reserved for future vesting of performance-vested stock units under the assumption that these awards met the criterion to vest at their maximum multiplier. At the Company's annual meeting of shareholders on May 18, 2018, the Company will request approval to increase the common shares authorized for grant under the 2015 Equity Incentive Plan to 10,500,000. In the event that this approval is not received, the grants exceeding the presently approved limit will be settled with cash.

The amount of stock-based compensation was as follows (in thousands):

Stock options

No stock options were granted during the three and nine months ended September 30,March 31, 2018 or 2017. During the periods presented, the Company granted the following stock options:

The following table summarizes information about issued and outstanding stock options as of September 30, 2017:March 31, 2018:

The estimated unrecognized compensation cost from stock options not vested as of September 30, 2017,March 31, 2018, which will be recognized ratably over the remaining vesting phase, is as follows:

Restricted stock units and stock bonus awards

The Company grants restricted stock units and stock bonus awards to directors, eligible employees, and officers as a part of its equity incentive plan.  Restrictions and vesting periods for the awards are determined by the Compensation Committee of the Board of Directors and are set forth in the award agreements. Each restricted stock unit or stock bonus award represents one share of the Company’s common stock to be released from restrictions upon completion of the vesting period. The awards typically vest in equal increments over three to five years. Restricted stock units and stock bonus awards are valued at the closing price of the Company’s common stock on the grant date and are recognized over the vesting period of the award.

The following table summarizes activity for restricted stock units and stock bonus awards for the ninethree months ended September 30, 2017:March 31, 2018:

The estimated unrecognized compensation cost from restricted stock units and stock bonus awards not vested as of September 30, 2017,March 31, 2018, which will be recognized ratably over the remaining vesting phase, is as follows:

Performance-vested stock units

The Company grants two types of performance-vested stock units ("PSUs") to certain executives under its long-term incentive plan. The number of shares of the Company’s common stock that may be issued to settle PSUs ranges from zero to two times the number of PSUs awarded. The shares issued for PSUs are determined based on the Company’s performance over a three-year measurement period and vest in their entirety at the end of the measurement period. The PSUs will be settled in shares of the Company’s common stock following the end of the three-year performance cycle. Any PSUs that have not vested at the end of the applicable measurement period are forfeited.

The fair value of the TSR PSUs was measured at the grant date with a stochastic process method using a Monte Carlo simulation. A stochastic process is a mathematically defined equation that can create a series of outcomes over time. These outcomes are not deterministic in nature, which means that by iterating the equations multiple times, different results will be obtained for those iterations. In the case of the Company’s TSR PSUs, the Company cannot predict with certainty the path its stock price or the stock prices of its peers will take over the performance period. By using a stochastic simulation, the Company can create multiple prospective stock pathways, statistically analyze these simulations, and ultimately make inferences regarding the most likely path the stock price will take. As such, because future stock prices are stochastic, or probabilistic with some direction in nature, the stochastic method, specifically the Monte Carlo Model, is deemed an appropriate method by which to determine the fair value of the TSR PSUs. Significant assumptions used in this simulation include the Company’s expected volatility, risk-free interest rate based on U.S. Treasury yield curve rates with maturities consistent with the measurement period, as well asand the volatilities for each of the Company’s peers.

The fair value of the TSR PSUs granted during the ninethree months ended September 30,March 31, 2018 and 2017 and 2016 was $5.1$4.2 million and $4.0$5.1 million, respectively. As of September 30, 2017,March 31, 2018, unrecognized compensation cost for TSR PSUs was $5.8$8.4 million and will be amortized through 2019.2020. A summary of the status and activity of TSR PSUs is presented in the following table:

We evaluate and update our estimated annual effective income tax rate on a quarterly basis based on current and forecasted operating results and tax laws. Consequently, based upon the mix and timing of our actual earnings compared to annual projections, our effective tax rate may vary quarterly and may make quarterly comparisons not meaningful. The quarterly income tax provision is generally comprised of tax expense on income or benefit on loss at the most recent estimated annual effective tax rate, adjusted for the effect of discrete items.

The effective tax rates for the three and nine months ended September 30,March 31, 2018 and 2017 were 8% and 2016 were nil.nil, respectively. The effective tax rates for the three and nine months ended September 30,March 31, 2018 and 2017 and 2016 were based upon a full year forecasted tax provision and differsdiffered from the statutory raterates due primarily due to the recognitionrelease of a valuation allowanceallowances previously recorded against deferred tax assets. There were no significant discrete items recorded during the three and nine months ended September 30, 2017 and 2016.

As of September 30, 2017,March 31, 2018, we had no liability for unrecognized tax benefits. The Company believes that there are no new items nor changes in facts or judgments that should impact the Company’s tax position.  Given the substantial NOL carryforwards at both the federal and state levels, it is anticipated that any changes resulting from a tax examination would simply adjust the carryforwards and would not result in significant interest expense or penalties.  Most of the Company's tax returns filed since August 31, 2011 are still subject to examination by tax authorities. As of the date of this report, we are current with our income tax filings in all applicable state jurisdictions, and we are not currently under any state income tax examinations.

No significant uncertain tax positions were identified as of any date on or before September 30, 2017.March 31, 2018.  The Company’s policy is to recognize interest and penalties related to uncertain tax benefits in income tax expense.  As of September 30, 2017,March 31, 2018, the Company has not recognized any interest or penalties related to uncertain tax benefits.

Sales of oil, natural gas, and NGLs are recognized at the point control of the product is transferred to the customer and collectability is reasonably assured. All of our cumulative losses through September 30, 2017,contracts’ pricing provisions are tied to a market index, with certain adjustments based on, among other factors, whether a well delivers to a gathering or transmission line, quality of the oil or natural gas, and prevailing supply and demand conditions. As a result, the price of the oil, natural gas, and NGLs fluctuates to remain competitive with other available oil, natural gas, and NGLs supplies.

Under our natural gas processing contracts, we deliver natural gas to a midstream processing entity at the wellhead or the inlet of the midstream processing entity’s system. The midstream processing entity gathers and processes the natural gas and remits proceeds to us for the resulting sales of NGLs and residue gas. For these contracts, we have provided a full valuation allowance reducingconcluded the midstream processing entity is our customer. We recognize natural gas and NGLs revenues based on the net realizable benefits.amount of the proceeds received from the midstream processing.